Average True Range

The Average True Range (ATR) is a technical analysis indicator used to measure market volatility. It was developed by J. Welles Wilder Jr. and is commonly used in the trading of financial assets like stocks, forex, and commodities.

Definition

The ATR does not indicate market direction or trend but provides an indication of the degree of price volatility. Strong moves, in either direction, often lead to high ATR values, whereas weak moves often lead to low ATR values.

Calculation

The ATR is calculated based on the ‘true range’ of a stock or asset over a specified period. The true range is the greatest of the following:

1. Current High minus the current Low
2. Current High minus the previous Close (absolute value)
3. Current Low minus the previous Close (absolute value)

The ATR is the moving average (typically a 14-day period) of these true ranges.

Example

Let’s calculate the ATR for a hypothetical asset over three days:

• Day 1: High = $102, Low = $98, Previous Close = $100
• Day 2: High = $105, Low = $101, Previous Close = $102
• Day 3: High = $107, Low = $104, Previous Close = $105

First, calculate the True Range for each day:

• Day 1 True Range:
  • $102 – $98 = $4
  • $102 – $100 = $2 (absolute value)
  • $98 – $100 = $2 (absolute value)
  • True Range = max($4, $2, $2) = $4
• Day 2 True Range:
  • $105 – $101 = $4
  • $105 – $102 = $3 (absolute value)
  • $101 – $102 = $1 (absolute value)
  • True Range = max($4, $3, $1) = $4
• Day 3 True Range:
  • $107 – $104 = $3
  • $107 – $105 = $2 (absolute value)
  • $104 – $105 = $1 (absolute value)
  • True Range = max($3, $2, $1) = $3

Next, calculate the ATR (assuming a 3-day ATR for simplicity):

ATR = (Day 1 TR + Day 2 TR + Day 3 TR) / 3 = (4+4+3) / 3 ≈ 3.67

So, the 3-day ATR for this asset is approximately $3.67.

Usage in Financial Analysis

• Volatility Assessment: ATR helps traders understand the volatility of an asset, which can be crucial for setting stop-loss orders and positioning size.
• Market Sentiment: High ATR values may indicate increased market interest or significant news affecting the asset, while low ATR values suggest a lack of interest.
• Trend Confirmation: In combination with other indicators, ATR can help confirm the strength of a trend.

It’s important to note that the ATR is not a directional indicator. It does not indicate the direction of the price movement, only the level of volatility.